Development Economics Development Microeconomics (by) Bardhan and Udry Chapter 7
Rural credit markets [1] Importance Smoothing consumption in an environment where production is risky and insurance markets are incomplete Types of credit Zero interest loans between friends and relatives Formal sector loans backed by collateral Loans offered by professional moneylenders, some of which is backed by collateral Tied loans offered by traders to farmers Consumption loans offered by employers to long-term employees Group loans offered by microfinance institutions to groups of borrowers who lack collateral
Rural credit markets [2] Types of government intervention Interest rate ceilings Directed credit Rationale for intervention Credit is an important input for agricultural production It is unfair to not have credit available to farmers Consequences of intervention Financial repression» Reduction in supply of loanable funds» Increase in demand for credit leading to rationing and hence rent seeking behaviour
Modelling rural credit market [1] Assumption Both borrowers and lenders are risk neutral A farm yields 0 if harvest fails and R>1 if there is a successful harvest The probability of success is π(a) ) when a is effort π(a) ) is increasing and concave, a [0, 1] A farmer has a cost of supplying effort D(a) D(a) ) is strictly increasing and convex
Modelling rural credit market [2] Success Failure Borrower R i D(a) Lender - D(a) 0 Implicit assumptions: - No problem of enforcement in the event of success - Limited liability in the event of failure Why would borrowers repay? - Fear of not getting credit in the future - Fear of social sanctions i Borrower s s cost of borrowing 1 < ρ < R Reservation payoff of borrower 0 < W < R Implication: i < R Expected returns: Borrower:» π(a)( )(R i) D(a) Lender:» π(a)i
Modelling rural credit market [3] i Π(i, a) = ρ Borrowers problem Max π(a)(r i) D(a) Sub π(a)i > ρ π(a)(r i) D(a) > W Choice variables: i and a U(i, a) = W 0 a In equilibrium Borrower gets at least reservation utility Lender recovers at least cost of funds There is no (i,( a) ) combination that is more preferred
Introducing moral hazard The lender cannot observe the effort put into the production process by the borrower Incentive compatibility constraint π(a)(r i) D(a) > π(a )(R i) D(a ) In equilibrium, lower a chosen by borrower than in the perfect information case Collateral Complications of risk aversion on the part of the borrower Need for secondary market for collateral Rapid rise of group lending when groups are typically homogeneous
The village moneylender Monopolist moneylender Max iπ(a) Sub π(a)( )(R i) D(a) > W iπ(a) > ρ Can observe the borrower s s effort costlessly Drives the borrower down to his reservation utility Moneylender facing outside competition Moneylender continues to observe borrowers efforts costlessly Outside competitor has a high cost of monitoring the borrowers Outside borrowing opportunities increase reservation payoff for the borrowers Moneylender has the same optimisation problem, but with a higher reservation utility in participation constraint
Introducing adverse selection [1] Q L N 1 + N 2 S L N 1 D L Q L i*(1) i e i Supply of fund: Q(ρ) EΠ(i), ρ
Introducing adverse selection [2] Moneylender Can enforce separating equilibrium In case of outside competition, two-tier tier credit market Collateral Reduce the impact of adverse selection Increase income inequality if returns from farming is higher than returns on labour for landless labourers